Quality Dimension of Value Investing: Graham to Greenblatt

Benjamin Graham will always be remembered as the father of value investing. Today he is primarily associated with selecting stocks on the basis of valuation metrics like price-to-earnings or market-to-book ratios. But Graham never advocated just buying cheap stocks. He believed in buying undervalued firms, which means buying high quality firms cheaply.

Graham was just as concerned with the quality of a firm’s assets as he was with the price that one had to pay to purchase them. According to Graham, an equity investor should “…apply a set of standards to each [stock] purchase, to make sure that he obtains (1) a minimum of quality in the past performance and current financial position of the company, and also (2) a minimum of quantity in terms of earnings and assets per dollar of price” (Graham 1973, pp. 183). Of the seven “quality and quantity criteria” that Graham suggested a firm should meet for inclusion in an investor’s portfolio, five were directly concerned with firm quality, while only two were related to valuation.

While Graham devoted as much attention to the quality dimension of value as its price dimension, he is nevertheless primarily associated with buying firms cheaply because it is his valuation metrics that have delivered exceptional returns. Value investing is on average quite profitable, but the quality metrics Graham employed have not reliably forecast relative stock performance. The last decade has seen resurgent interest, however, in quality investing.

Quality is often viewed as an attractive alternative to traditional growth, which performed terribly during and after the dot-com bust. Its leading industry proponents include GMO’s Jeremy Grantham, whose high quality indicators of “high return, stable return, and low debt” have shaped the design of MSCI’s Quality Indices, and Joel Greenblatt, whose “Little Book that Beats the Market” has encouraged a generation of value investors to pay attention to capital productivity, measured by return on invested capital, in addition to valuations.

Novy-Marx suggests that Value metrics work better when combined with Gross Profitbaility, especially for large liquid stocks. In another paper he also analyses various valuation methods – Greenblatt’s Magic Formula, Grantham’s Quality, Ben Graham investing and Sloans accruals.